How It All Started In 1997

The 1997 Asian financial crisis marked a shift in the global balance of payments that, arguably, led to the U.S. financial crisis in 2008. Prior to the Asian financial crisis, many economies in Asia – most notably, Thailand, Indonesia, and South Korea – experienced large asset bubbles due to excessive capital inflows from overseas. Those capital inflows bid up the price of everything from stocks to real estate to commodities.

Once investors realized that growth in developing Asia was being driven by unsustainable asset bubbles – after all, productivity growth in that region was not very impressive during the 1990s – the capital inflows stopped, causing a currency crisis in 1997. Currencies such as the Thai baht and the South Korean won experienced sharp devaluations. The currency devaluations inevitably led to a wave of corporate bankruptcies and to a massive credit crunch. Then – and this is not dissimilar to what happens in the United States whenever corporations go bust amid a widespread credit crisis – many governments in Asia stepped in to bail out failing companies, leading to a rapid accumulation of public sector debt. To handle the public sector debt burden, many governments in Asia turned to the International Monetary Fund (IMF) for assistance.

The IMF then did to Southeast Asia what the Germans are currently doing to peripheral Europe; that is, the IMF provided a bailout conditional on the implementation of harsh austerity programs and various structural reforms, in hopes of restoring investor confidence to the economies affected by the currency crisis. Among other things, the IMF also thought that it would be a good idea to raise interest rates in the aftermath of an asset bubble collapse – kinda like how the European Central Bank thought it would be a good idea to raise interest rates in mid-2011. Anyhow, as economic theory predicted at the time, the IMF’s bailout conditions served to prolong the economic slump in Southeast Asia.

Suffice it to say, policymakers in Southeast Asia were not happy with the IMF’s involvement. So, following the crisis, they sought an economic strategy that would never again put their citizens’ well-being at the mercy of the IMF. It turns out that all they had to do to find such a strategy was to look to their northern neighbors, the Chinese.

The Chinese economy emerged from the Asian financial crisis relatively unscathed. While most other economies in Asia saw their currencies collapse, the Chinese yuan maintained its value throughout the crisis:

The truth, though, is that the Chinese were implicitly planning for the Asian financial crisis long before the crisis began.

The Chinese began to devalue the yuan against the dollar in the early 1980s. The reason for this policy was two-fold: (1) China sought an export-led growth model, and a currency devaluation improved the competitiveness of Chinese exports; and (2) China sought enough foreign-currency reserves to protect itself against forthcoming financial crises. On the latter point, it made sense for China to devalue against the dollar, primarily because the dollar was, and still is, the world’s principle reserve currency. Relatedly, China also maintained strict capital controls on money flowing into and out of its economy, essentially making foreign-investment-led asset bubbles less likely. It was for all of these reasons that the Chinese economy held up pretty well during the Asian financial crisis.

In effect, the policymakers in Southeast Asia looked at their northern Chinese neighbors and said, “Hey, that model looks pretty good.” And so they replicated it, choosing to maintain artificially weak currencies against the dollar – many countries in Southeast Asia simply pegged their currencies to the Chinese yuan. The J.P. Morgan Asia Dollar Index, which tracks the value of the U.S. dollar against 10 other Asian currencies (excluding the yen), depicts the conscious devaluation effort that Southeast Asia made following the financial crisis:

The predictable outcome of a sharp currency devaluation in Asia against the dollar is a large U.S. trade deficit. Not surprisingly, the U.S. trade deficit exploded shortly after the Asian financial crisis erupted:

The problem, however, is that a large U.S. trade deficit with developing Asia is the exact opposite outcome that neoclassical trade theory would predict.

Neoclassical trade theory states that rich, developed economies should be capital exporters to the developing world; because rates of return are typically higher in the developing world. When capital flows from the developing world to the developed world, the predictable outcome is an asset bubble in the developed world, as capital that is forced to seek higher rates of return in a low-return economy will ultimately make its way into risky investments.

Rather than recognizing this development as potentially harmful to the U.S. economy, policymakers in the United States cheered the massive trade deficit. To them, the trade deficit implied a strong currency, which would keep domestic inflationary pressures low. And the conventional wisdom in Washington is that inflation is always a very bad thing.

So the trade deficit grew, leading to asset bubbles in the United States, just like economic theory predicted. First a bubble occurred in technology stocks – companies like pets.com with zero profitability were going public for billions of dollars. Then a bubble erupted in real estate, inflating prices and construction activity for both residential and commercial properties.

The thing about trade deficits, though, is that they necessarily imply debt accumulation. When the U.S. economy runs a trade deficit with the developing world, this means that it must borrow money from the rest of the world to finance the trade deficit.[1] And the borrowing must occur in either the private sector, the public sector, or in some combination of both sectors.

In the 2000s, the private sector was a huge net borrower. The U.S. household saving rate fell to nearly 1 percent in 2005, and capital investment by U.S. businesses was very strong. Then, when the real estate bubble burst in 2006, the private sector moved from a large net borrowing position to a large net saving position. Since the trade deficit was still kicking at this time, the implication was that large budget deficits in the public sector had to emerge. Again, this is an accounting identity: The public sector necessarily had to move to a huge net borrowing position in order to finance the trade deficit, because the private sector was no longer in a position to finance it. This is where we are today, with the public sector still running large budget deficits and with the private sector still deleveraging.

Unfortunately, the imbalances still have not corrected. The United States continues to run a massive trade deficit with the developing world, meaning that the conditions for another asset bubble to emerge are ripe. But then again, maybe that’s the plan: To continuously inflate asset bubbles for rent-seeking purposes. After all, the financial sector thrives off asset bubbles – how many executives on Wall Street walked away with hundreds of millions of dollars after their companies failed in 2008? – and it is well known that the financial sector has a tremendous amount of political influence in Washington.

Normalizing the global trade imbalances, of course, requires a weaker dollar, which would increase the export competitiveness of the U.S. economy. To be sure, reducing the value of the dollar involves geopolitical compromises; for example, U.S. policymakers could loosen various patent and copyright laws that give multinational corporations excessive monopoly power overseas in exchange for faster yuan appreciation.[2] But there doesn’t seem to be any political will to make such compromises – especially when policymakers in the United States have so many other important things to worry about, such as how to drug test unemployment-insurance recipients or how to slash Social Security retirement benefits, on which millions of retirees are dependent because they saw their savings evaporate during the housing collapse.[3]

The real wonder is: For how long will the American people tolerate the boom-bust model that has gripped the U.S. economy? The people of Europe have clearly had enough, as evidenced by the growing popularity of socialism and fascism in some countries. Hopefully, we won’t ever find out the answer to that question. But so long as policymakers continue to ignore trade imbalances, discovering that answer may prove to be inevitable.

[1] I’m well aware that the identity here is driven by the current account balance and not the trade balance. But since the trade deficit is the primary driver of the current account deficit in the United States, I’m using the words “current account deficit” and “trade deficit” interchangeably.

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There should have been a conscious effort to not let the dollar become so strong against the currencies in Asia. Such a policy would have prevented the trade deficit from growing to absurd levels. As I mentioned in my post, the debt buildup in the private sector was directly related to the trade deficit; this is an accounting identity. Without the debt overhang, this slump would be over. And without the trade deficit, the debt overhang wouldn’t exist.

“The currency devaluations inevitably led to a wave of corporate bankruptcies …”

This doesn’t seem inevitable to me, rather it seems counterintuitive. You’re saying the slowdown of capital inflows caused the devaluation, which caused bankruptcies. Did you mean that no capital inflows caused both the devaluation and the bankruptcies? How does devalutions cause bankruptcies?

“Unfortunately, the imbalances still have not corrected. The United States continues to run a massive trade deficit with the developing world”

After that, you have the conscious devaluations, which of course contributed to the US trade deficit. However, you later say that the “imbalances still haven’t corrected”. I’m not convinced that a devalution in Asisa 14 years ago (I’m going by your story here, I don’t know much about Asia) has much bearing on the current trade deficit. The reason a devaluation increases exports is that the exchange rate adjusts immediately while other prices don’t, which makes this nominal change have real effects. Are you saying prices haven’t adjusted, or is there some other argument?

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Many companies in Southeast Asia issued debt in U.S. dollars in the 1990s. So when their local currencies collapsed, the debt became much harder to pay off, leading to bankruptcies. This dynamic was especially true in Thailand.

Of course, the IMF’s interest rate hikes also contributed to the bankruptcies. Credit was already difficult to obtain, and the IMF’s policies just made the problem worse.

“Are you saying prices haven’t adjusted?”

In a way, yes. “Flexible inflation targeting” at the Fed has been code for “we must keep inflation around 2% or the world will end.” You would think that prices would have adjusted to a devaluation that occurred 14 years ago, but the fact remains that the U.S. is still running a very large trade deficit. This suggests that very little adjustment has been made.

One point that I left out, which I’ve mentioned before, is that the trade deficit is also in part driven by petroleum imports. In other words, a price/currency adjustment isn’t the whole story; we also need a coherent energy policy. In this area, I favor Pigovian taxes, but there are other useful strategies that could help, such as more urbanization. Oh, and more bike lanes!

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[…] to the dollar at artificially cheap rates – the currency manipulation game started after the 1997 Asian financial crisis. Given that developing Asia is having its own growth problems at the moment, it’s highly unlikely […]